Introduction: Pricing as an Element of the Marketing Mix

[Pages:18]CHAPTER 1

Introduction: Pricing as an Element of the Marketing Mix

Anytime anything is sold, there must be a price involved. The focus of this book is to

present concepts, principles, and techniques that provide guidance to help a seller set the best price.

Our study of how to set the best prices will take the marketing approach. In this chapter, we will describe the business context for pricing and provide an overview of how the basic principles of marketing can guide effective price setting.

THE COMMERCIAL EXCHANGE

Although people often think of marketing as synonymous with advertising or salesmanship, it is actually much broader. Marketing consists of the full range of activities involved in facilitating commercial exchanges and having all of these activities be guided by a concern for customer needs.

The central idea here is that of the commercial exchange (see Figure 1.1). This is where a seller provides a product to a buyer in return for something in exchange (usually an amount of money). The product could be something tangible, which is referred to as a good, or the product could be the result of human or mechanical effort, which is referred to as a service. The buyer could be a consumer--an individual who purchases a product for his or her own use--or the buyer could be a business customer-- an individual or group who purchases the product in order to resell it or for other business purposes.

One aspect that makes the commercial exchange a very important idea is that it describes an interaction that is voluntary. Both the buyer and seller participate in the exchange voluntarily because the exchange will lead them both to be better off. For example, consider the vending machine in the office lounge. You put in your dollar and get a large package of M&M's. You do that voluntarily because you would rather have the bag of candy than that dollar. On the other hand, the Mars company, which produces M&M's, also

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Figure 1.1 The Commercial Exchange

Seller

Product

Something in exchange

Buyer

? Product: good or service ? Buyer: consumer or business customer ? Something in exchange: price

Source: Adapted from W. M. Pride and O. C. Ferrell, Marketing: Concepts and Strategies (Boston: Houghton Mifflin Co).

engages in this transaction voluntarily. As we know, the company would rather have your dollar than that extra package of candy.

Although we tend to take commercial exchanges for granted, we shouldn't forget that there is something very important and wonderful involved here. Because both parties to the exchange are better off after the exchange than before, one could say that the exchange makes the world a just a little bit better place. There is a little more happiness after the exchange than before it. Although there may be only a tiny bit of increased happiness from any one commercial exchange, these little pleasures can quickly mount up. In a society where the distribution of most goods and services is governed by a free-market economy, every person engages in numerous commercial exchanges every day. Each little increase in pleasure that a commercial exchange brings is then multiplied many times, and the societal benefits can become considerable.

In all of this, it must be recognized that there are degrees of voluntariness, and that choices may be so limited for some buyers that they may not feel much better off after an exchange. Also, it is possible that a product purchased voluntarily could fail to perform as expected or that a third party (other than the buyer and seller) may be harmed by an exchange. These illustrate the need for some governmental regulation--a free-market economy cannot be entirely free. Nevertheless, in modern free-market societies, people experience the pleasures of choice and are energized by entrepreneurial possibilities. The commercial exchange is at the heart of the free-market economic system, which, as we have seen in recent years, has become more and more widely adopted among the various nations of the world.

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WHAT IS A PRICE?

From this understanding of the commercial exchange, we are now able to give a formal definition of a price: that which is given in return for a product in a commercial exchange.

This essential role of price in commerce is sometimes disguised by the use of traditional terms. If the product in the commercial exchange is a good, then the product's price will most likely be called "price." However, if the product is a service, then the product's price may well go by one of a variety of other possible names (see Figure 1.2).

Figure 1.2 Some Terms Used to Mean "Price"

Alternative Terms Price Tuition Rent Interest Fee Premium Fare Toll Salary Wages Commission

What Is Purchased most goods college courses, education use of a place to live or use of equipment for a period of time use of money professional services: for lawyers, doctors, consultants insurance transportation: air, taxi, bus use of a road or bridge, or longdistance phone rate work of managers work of hourly workers sales effort

Source: Adapted from Thomas C. Kinnear and Kenneth L. Bernhardt, Principles of Marketing, 2nd ed. (Glenview, IL: Scott, Foresman and Company, 1986), 546.

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"Price" Versus "Cost"

Although a price may go by many names, one name it should not go by is cost. This is because, in this book, we will usually be taking the viewpoint of the seller.

If we were taking the viewpoint of the buyer, this would not be an issue. Buyers, particularly consumers, will typically use the terms price and cost synonymously. For example, a woman could tell her friend, "The price of this sweater was only $30." Or she could just as easily say, "This sweater cost me only $30."

However, from the viewpoint of the seller, the difference between prices and costs is quite important. A price is what a business charges, and a cost is what a business pays. Thus, a grocery manager may set a price of $3.79 for a 17-ounce box of Honey Nut Cheerios, may price large navel oranges at 3 for $1.99, or may sell ground chuck at the price of $3.49 per pound. But the manager must also attend to his costs. These costs include, for example, what he pays the wholesaler per case of Cheerios, what he pays employees to stock it on the shelves, what he pays for the building, for heat and lights, for advertising, and so on.

PRICING AS A MARKETING ACTIVITY

Marketing activities are those actions an organization can take for the purpose of facilitating commercial exchanges. There are four categories of marketing activities that are particularly important, which are traditionally known as the four elements of the marketing mix:

? Product--designing, naming, and packaging goods and/or services that satisfy customer needs

? Distribution--efforts to make the product available at the times and places that customers want

? Promotion--communicating about the product and/or the organization that produces it

? Pricing--determining what must be provided by a customer in return for the product

If you use the term place for the activities of distribution, the four elements of the marketing mix can be referred to as "the four Ps," a mnemonic that has proved useful to generations of marketing students.

Note that there is an important way in which pricing differs from the other three elements of the marketing mix. This is illustrated in Figure 1.3. Product, distribution, and promotion are all part of the process of providing something satisfying to the customer. Product activities concern the design and packaging of the good or service itself, distribution involves getting the product to the customer, and promotion involves communicating the product's existence and benefits to customers and potential customers. All three of these types of marketing activities contribute to the product being of value to customers. In this book, the term value will refer to the benefits, or the satisfactions of needs and wants, that a product provides to customers.

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Figure 1.3Pricing Harvests the Value Created by the Other Three Marketing Mix Elements

Product Distribution Promotion

Create value

Pricing

"Harvests" value

Source: Based on Nagle (1987).

Pricing, on the other hand, is not primarily concerned with creating value. Rather, it could be said to be the marketing activity involved with capturing, or "harvesting," the value created by the other types of marketing activities.1 In the words of Philip Kotler, "Price is the marketing-mix element that produces revenue; the others produce costs."2 Because it is a marketing activity fundamentally different than the others, it is important that the implications of pricing's uniqueness be fully understood. This is one of the reasons that a course in pricing is an important part of a business education.

The Marketing Concept

The marketing approach to business involves not only engaging in a variety of marketing activities but also having these marketing activities be guided by the marketing concept. The marketing concept can be expressed as follows: The key to business success is to focus on satisfying customer needs.

What this means is that an organization that works toward satisfying customer needs in every feasible way when carrying out marketing activities is likely to see more long-run success than a company that does not have such a customer focus. Sellers who rely only on their own opinions and ignore those of their customers or sellers who view their customers as "marks" to be tricked or manipulated may do well at a particular time but are unlikely to be able to sustain whatever short-term success they may have. The marketing concept is a modern form of the philosophical viewpoint known as "enlightened self-interest": One's self-interest is best served by focusing one's attention on the needs of others.

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Pricing and the Marketing Concept

It is clear how product, distribution, and promotional activities can be guided by the marketing concept. Through marketing research (which, by the way, is a fifth important category of marketing activities), a personal computer manufacturer can learn, for example, the features and styling consumers want and then build machines to satisfy consumer preferences. A bank could determine the hours consumers would prefer walk-in service and could arrange to have those services available during those hours. A cell phone service provider may find out that many consumers are unaware of all of the convenient features of their service and may design a promotional program to communicate this information.

However, it is less clear how pricing activities can be guided by the marketing concept. Certainly, customers would prefer paying less. In fact, paying nothing at all might well be their first choice! But it is simply not feasible to "give away the store." An organization that gives away the value it creates will soon cease to exist, and thus the value it creates will disappear. This does not serve customers well. Rather, it is in the customer's interest for an organization that creates customer value to set prices that maximize the organization's profitability, since that would give the organization the greatest possible chance of continuing to create that value.

Lest this endorsement of profit maximization sound somewhat extreme, rest assured that in a free-market system, competition will tend to keep maximum profits modest. Nothing attracts competitors more quickly than a highly profitable product. Further, the marketing concept points the price setter to consider not only the customer value that can be harvested but also the customer's feelings about the price that is being charged. Examples of such price feelings that need to be considered include the following:

? The feeling of a price being substantially higher than the customer's expectations (sometimes referred to as "sticker shock")

? The feeling that a price is unfair or is higher than can be justified

? Customers perceiving they are receiving a discount, or a price lower than their expectations

It is important to note that both identifying the value that the product represents to the customer and considering customers' price expectations and feelings depend on understanding and attending to customer needs. Both of these aspects of the marketing approach to pricing will be discussed in detail in later chapters.

EARLY PRICING PRACTICES

As you might imagine, the practice of pricing has a very long history. Consider the following:

The oldest records of prices ever found are clay tablets with pictographic symbols found in a town known as Uruk, in what was ancient Sumer and what is now southern Iraq. These price records are from 3300 BC--they've survived 5,300 years. The documents--records of payment for barley and wheat, for sheep, and for beer--are really receipts. "Uruk was a

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large city, at a minimum 40,000 people," says UCLA professor Robert Englund, one of the few experts on the Uruk documents. "So some of the quantities are very high--hundreds of thousands of pounds of barley, for instance."

But here's the really remarkable thing. The earliest Uruk tablets aren't just the oldest pricing records ever found. They are the oldest examples of human writing yet discovered. In other words, when humans first took stylus to wet clay, the first things that they were compelled to record were...prices.3

In the earliest commercial exchanges, goods or services were exchanged for other goods or services. For example, the price that a farmer might pay for a bolt of cloth could be a bushel of corn. This practice, termed barter, still goes on today, especially in less developed countries. Barter occurred in recent years when Shell Oil purchased sugar from a Caribbean country by giving in return one million pest control devices.4 Although barter is still used, it can make exchange difficult. For example, what if the seller of the bolt of cloth had no need for the farmer's bushel of corn? Because of such inefficiencies of barter, almost all modern commercial transactions use a medium of exchange--something that is widely accepted in exchange for goods and services in a market.5

A medium of exchange could be anything that the buyers and sellers in a society agree upon. In the past, items such as cattle, seashells, dried cod, and tobacco have been used as a medium of exchange. However, many of these presented certain difficulties. In his book The Wealth of Nations, Adam Smith gives an example of this:

The man who wanted to buy salt, for example, and had nothing but cattle to give in exchange for it, must have been obliged to buy salt to the value of a whole ox, or a whole sheep, at a time. He could seldom buy less than this, because what he was to give for it could seldom be divided without loss....6

Over time, it became clear that the best medium of exchange is one that is finely divisible, such as the metals of various weights used in coins. This use of coins and notes to represent them led to national systems of money, such as dollars, yen, or euros. It is prices expressed in such monetary terms that will be considered in this book.

THREE CATEGORIES OF PRICING ISSUES

As the use of prices in monetary terms proliferated among human societies, various questions that required pricing decisions began to arise. Most of these issues fall into one of the following three categories: (1) buyer?seller interactivity, (2) price structure, and (3) price format.

Buyer?Seller Interactivity in Determining Prices

Throughout most of history, prices were not the fixed amounts displayed in stores and advertising that are so familiar today. Rather, prices were negotiated during an interaction

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between the buyer and the seller. The basic elements of price negotiation can be illustrated by imagining how, for many centuries, the price determination process typically occurred:

A customer arrives at the seller's stall in the local marketplace and examines the merchandise. When he finds something he wants, the customer asks the seller, "How much?" The seller then states an asking price, which is higher than his reservation price, the lowest price at which he would sell the item: "23 ducats." The customer then states his initial offer. This, of course, is lower than the customer's reservation price (the highest price that the customer would pay for the item): "I can't pay more than 14."

The seller and the customer would then try to arrive at an amount they can both agree on by haggling, a process involving some number of prices and offers and statements supporting the validity of each. "This item is really of the very highest quality," the seller might argue, "but since I'm in a good mood today, I'll let you have it for 21." The customer might respond, "I've seen items at least as good as this in other shops, but since I'm here, I'll give you 16."

If there is overlap between the reservation price of the seller and that of the customer, then they could be successful in arriving at a negotiated price--that is, one that is agreeable to both. In that case, the object's price would have been the number that resulted from an interaction between the buyer and seller. A price arrived at by the buyer?seller interactions of negotiation or the interactions of auction bidding would be referred to as an interactive price.

If you find yourself a little uncomfortable with the deception involved in the process of price negotiation, you are not alone. Religious leaders were among the earliest critics of this type of business practice. In fact, it was George Fox, the founder of the Society of Friends (often called the Quakers), who first suggested that an alternative was possible. He led his followers to carry over to their businesses the principle of total honesty that they adhered to in their personal lives. As a result, Quaker merchants adopted the practice of stating to the customer the price that they actually expected to receive and sticking to it. Such a price is referred to as a fixed price.

It is interesting that, rather than hurting their competitive position, the use of fixed prices actually tended to help the Quakers in their businesses. Customers appreciated the quicker and less stressful buying process associated with fixed prices and often tended to feel more trusting of Quaker merchants. The use of fixed prices spread steadily and was strongly stimulated by the development, in the middle of the nineteenth century, of new types of retailing designed to serve mass markets. In particular, fixed prices helped make possible the large department store (pioneered by entrepreneurs such as F. W. Woolworth, John Wanamaker, and J. L. Hudson), which depended on a large number of quick transactions and staffing by low-paid, relatively unskilled clerks. In an 1859 advertisement for his growing New York department store, Rowland Macy claimed, "Best products, and same prices for all customers!" Also, the use of fixed prices enabled the growth of mail-order sales and the development of large catalog companies such as Sears Roebuck.7

During the twentieth century, the use of fixed prices became predominant in retail pricing throughout the developed world. Although we take fixed prices for granted when we

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